Last week, I wrote an article for ConHome explaining how Budget forecasts had tended to be over-optimistic on future growth prospects for the UK economy. Today, I turn my attention to the Bank of England’s Monetary Policy Committee, whose remit is to keep inflation within a percentage point of the 2% target.
The UK CPI inflation rate is currently running at 4.5%. That’s a whole 2.5% above the target which the MPC is supposed to be hitting. But interest rates still aren’t being hiked. The Monetary Policy Committee is forecasting that deflationary pressures are such that inflation will fall in time, without the need for increased rates now. Current inflation, they argue, is largely imported – and besides, there is a large excess capacity in the economy.
Whilst the excess capacity of an economy is highly difficult to measure, there are reasons to suspect that in time inflationary pressures will subside: the impact of the VAT rise is temporary; commodity price jumps might begin to dampen, and the slow nature of the recovery coupled with government spending restraint will restrict aggregate demand. So rather than responding to short-term inflationary pressures, the MPC claim it is targeting longer-term inflation as justification for not raising rates today.
To target future inflation, however, requires a good track-record in forecasting inflation. Otherwise, it’s a pretty fruitless task. Unfortunately for the Bank, although its historic record here has been good, forecasts in recent years have been shown to display a steady underestimation of inflation, or what one might say ‘wishful thinking’.
A fact sheet released by the Centre for Policy Studies today shows how the Bank’s forecasting has deteriorated over the past ten years.
In the twelve inflation reports from August 2001 to May 2004, the Bank’s average forecast for inflation a year ahead was 2.2% p.a. Outturn inflation was 2.3% p.a. Therefore, there was an average error of just 0.1 percentage points, with the forecasts almost spot on.
In the next twelve quarterly reports from August 2004 to May 2007, there was an average underestimation of outturn inflation of 0.4 percentage points – a little optimistic, but still within forecasting margins.
But for the forecasting period in the inflation reports from August 2007 to May 2010, the average outturn has been 1.3 percentage points higher than the average forecast, and inflation has been above the 3% upper inflation limit for two of the past three years.
Now, there are good reasons to suggest why the forecasts may not have been so accurate for this period. We went through a deep recession, and there have been multiple shocks both to the global financial system and commodity prices. But what is interesting is the sustained direction of the bias – consistently underestimating inflation. Indeed, the forecasting figures for two years ahead give similar results.
I suspect that the Bank genuinely believes that deflationary forces will prevail in the medium-term, and am not necessarily advocating that a rise in rates would be good for the health of the economy – it is easy to see the benefit of low rates for business and consumer confidence. But the MPC’s remit is explicit in stating inflation targeting as its primary aim. Any further considerations around economic growth and business confidence are secondary, as the Bank operates independently from government.
The current low rates and moderate inflation are not politically neutral, with low rates helping to maintain confidence, as mentioned. In addition, it is almost in the interest of government for reasonable levels of inflation to allow real depreciation of both Government and bank debt.
The issue for the Bank surrounding its forecasting record is therefore about credibility. Do the public and the markets maintain trust in the Bank to be acting independently of government aims? Its poor forecasting record over the past few years is undermining the case it has made for low rates. And if credibility completely evaporates with persistent high inflation over the next 12 months, there is a risk that inflation could begin to spiral further as expectations adjust.